How to Play the Latest Dip in Oil and Gas

Here in the energy sector, the other shoe has just dropped. Natural gas prices have now declined to their lowest point since 2012.

This weakness, combined with another bout of lower crude oil prices, is putting pressure on energy producers. And the industry is struggling under a mountain of debt taken on by U.S. producers when prices were soaring.

But in any shakeout like the one under way, there are always investment opportunities.

And I’ve identified two specific ways you can profit despite the lows we’re seeing right now for oil and gas.

Here’s my take on what’s affecting the markets today… and the two ways to play the current low prices to your advantage…

How the Energy Debt Crisis Affects the Market

I have discussed the primary pressures colliding in the energy markets before in Oil & Energy Investor:

Most oil and gas producers have operated cash poor for most of the past decade. Prior to the decline in commodity prices, most companies would regularly finance forward capital expenses by floating debt. Cash receipts, on the other hand, would be reserved for dividends and (in the case of publicly traded enterprises) stock buybacks.

This was quite sustainable while oil was going for $80 a barrel and natural gas was pushing $12 per 1,000 cubic feet and higher. Debt was quite obtainable at reasonable rates, despite it being usually categorized as the least graded high-risk (i.e., “junk) part of the bond market.

However, these days, with oil at $45 a barrel and gas hitting $2, the prospects for a number of companies are becoming desperate. We are already into a cycle of mergers and acquisitions, with new versions of vertically integrated corporate structures occupying the spaces among upstream production, midstream transport/storage, and downstream processing/distribution.

Other companies are in the process of selling non-strategic assets to fend off creditors. That has opened up new opportunities for end users – refineries, pipeline holdings, and utilities – as well as competitors in the upstream space.

The Problem Will Get Worse Before It Gets Better

The debt situation will be getting worse before it improves, and that will leave a widening number of both private and traded producers in a vulnerable position. Until the end of the year, debt rollovers will become increasingly more expensive and difficult to obtain.

Some of the effects are already apparent. The significant pullback in forward capital commitments for new well projects has hit the more expensive part of the production curve hard.

This has initially centered about curtailing unconventional (shale and tight) oil and gas production requiring deeper, horizontal, fracked drilling. These wells are far more expensive than alternative vertical drilling. Despite the potential for a wider pay zone and enhanced volume, most of these projects cannot be justified at current market prices for either oil or gas.

The other major development has been a protracted (and continuing) decline in rig counts. Currently, the number of rigs in operation is 60% below the higher levels of only 12-18 months ago.

Curiously, the weekly decline no longer has a major impact on oil or gas prices. Those playing the commodity weakness as an opportunity to short raw materials or exercise other derivatives on futures pricing have been able to downplay the prospect of a lowering overall production level.

Of course, should that decline serve to buttress prices, it would require a quick covering of shorts to offset losses; these guys would actually have to work for a living via more conventional trading.

How to Find the Best Companies for Playing Oil and Gas

The best approach to making money in the sector right now remains one I have mentioned on several occasions. First, the current climate discourages project investment in large shale and tight oil/gas projects. The bigger boys can withstand the situation. But smaller companies cannot.

Look to exercise some put options at least a year out on select companies with decent assets already in production but facing a constriction of immediate revenue flow.

Yet, as noted above, not all drilling is in the same boat. What I call “VSF drilling” is cost effective and most likely to turn a nice profit even in low pricing environments, given the demand that remains for product.

“VSF” refers to vertical shallow, formula drilling. There is no need for expensive directional drilling or fracking. Wells are spudded only a few thousand feet deep, and work takes place in a patterned drilling approach on acreage having existing seismic work. Where a deeper shale well can easily cost $5 million or more to drill and complete (making a single dry hole a very expensive drawback for an entire drilling program), a VSF well can easily come in at $600,000 or less from start to finish. Even a 30% dry hole rate is sustainable and profits resulting from such an approach.

Companies that have successful management and project experience in particular basins where drilling is known, infrastructure is complete and operational, and positioning to end markets established, will experience the primary benefits, even with low prices.

And then there are the widening opportunities for acquisition of choice producing assets from companies needing immediate infusions of cash. Such acquisitions of existing volume at discount prices improve the receiving company’s booked reserve costs. This is what enhances share value, not the present amount of oil or natural gas sold.

All of this means there are some nice pops taking place with companies experiencing strong double-digit advances even while the pundits bewail the declining pricing prospects.

This is always the way money is made when oil and gas come under pressure. Stay tuned – I’ll be your guide to energy profits.

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